Let’s Talk About Crypto Exchanges
An exchange is a marketplace where securities, commodities and other financial instruments are traded.
In today’s world, most exchanges are centralized. Take for example the NYSE (New York Stock Exchange) and the LSE (London Stock Exchange). These are two of the world’s most famous and voluminous exchanges, specialized in stocks.
What is meant by “centralized” however? A centralized exchange is one where all orders of stocks or shares are routed to a singular place, such as the NYSE or LSE. These routed “ask” or “bid” orders all meet in the same place (either physically or on a server) and are matched locally.
With the rise of disruptive technology known as blockchain and its application of cryptocurrencies, a number of centralized exchanges specializing in the trading of cryptocurrencies have popped up. Some of the most famous and successful ones include Binance, Kraken, OKEx and Bittrex.
Centralized exchanges, first of all, pose a risk to people’s funds, especially within the cryptocurrency industry where many of these exchanges’ security is untested. Take Mt. Gox as an example, a hacking event where many people did not take the measures necessary to protect themselves and their funds. It is estimated that approximately 850,000 bitcoins, belonging both to the company and customers were “stolen”. A centralized exchange owns the balance available on “your” wallet, thus a hack which enters from the back-end of the exchange can gain access to the private key keeping your funds safe.
Secondly, due to the nature of centralized exchanges, it might be hard for them to offer high availability. Up until early 2018, Kraken was notoriously known to have connection issues and crash multiple times a day due to exactly that.
Another well-known issue with cryptocurrency exchanges today is the way some of them handle business. Let’s take HitBTC as an example, where many, many, MANY people have complained about the nature of the withdrawal fees on some of the altcoins listed. HitBTC has developed an infamous reputation due to this, and many people choose not to use HitBTC when trading altcoins.
Security and Fees: A Decentralized Solution
A decentralized exchange is a system where “ask” and “bid” orders are not routed to a singular location, but instead are matched on a Peer-to-Peer basis. This not only cuts out middlemen fees but also decreases the risk of the exchange being hacked for funds. The main difference is that a decentralized exchange does not own your private key to your wallet. You can keep funds on the exchange’s wallet, but you must sign any transaction which takes place using your private key (which the exchange does not have access to).
Many decentralized exchanges today are sub-par, however. Taking a look at EtherDelta we can see that users are having complaints about the speed which transactions are propagated at, and even the transaction fees. Perhaps two of the biggest glaring issues on exchanges such as EtherDelta are the immense latency problems, as well as the lack of finality.
Not to mention the fact that a mistake on a DEX can be a whole lot more costly than on its centralized counterpart. Decentralized exchanges simply do not have the protective barriers in place for users which (most) centralized exchanges do, thus sending an ERC-20 token to a non-ERC-20 wallet, for example, will “work”, but it also means that the tokens are forever lost in the void.
User Interface and Experience: The Downside
Despite the lower fees and higher security decentralized exchanges provide, they are still a long way from being considered the optimal way of trading digital assets. A well-known issue with decentralized exchanges is that they are not “noob-friendly”, meaning that people who are just learning about cryptocurrencies and would like to become market participants will have a hard time figuring out the mechanics and moving along the steep learning curve. A quick example of this would be the lack of market orders available on DEXs, which can hurt a large proportion of inexperienced traders, as they would instead be placing limit orders below the market price, and of course, more knowledgeable traders take advantage of this by either watching the books or setting up bots and making profits from arbitraging.
Listings: The Upside
When it comes to listings, centralized exchanges tend to have relatively high fees, although exchanges do not make this information public, sources have reported that Binance has charged up to $2.6M for listing a coin. This does not predicate fairness, and smaller projects stand at a disadvantage despite the technology, concept or team behind the project.
Decentralized exchanges ‘list’ any token as long as there is a supply and demand for them. Theoretically, an individual would be able to insert all the information of a token (decimals, ticker and contract address) and create a supply of that token on a DEX. This does not involve the exchange and ensures that tokens get listed based on the community’s interest and demand, rather than the exchange’s own agenda.
To conclude, today’s exchanges are faced with a plethora of issues, regardless of whether they are centralized or decentralized. Perhaps one exception could be made with the development of Binance’s own decentralized exchange, which does look promising.
Centralized exchanges pose a clear threat to all of their user’s funds, which is extremely dangerous especially for new users who opt for these centralized exchanges, as their user-interface is simpler to operate than their decentralized counterpart. However, we have looked into the fact that security is not the only issue, and that many of these exchanges have advantages and disadvantages from a financial point of view. An optimal exchange should be charging a small, flat fee for withdrawing tokens in order to attract as many customers as possible, instead of driving them away and developing a reputation, as HitBTC has done. Furthermore, we have seen how decentralized exchanges can help cut out middlemen fees due to their peer-to-peer nature, this is something which all exchanges should strive for. It is clear that neither of these exchange-types have the answer which users are looking for, and it is therefore why perhaps a hybrid solution where the best aspects of each exchange-type were considered and applied, would strive most in today’s market.
A centralized/decentralized hybrid could, in theory, provide the security features which decentralized users benefit from, all while having access to a simplified, user-friendly interface. Centralized exchange users could opt to, at any point, transfer all of their funds from their hot, centralized wallets into their cold, decentralized wallets. This would result in full protection of the user’s funds, regardless whether the centralized exchange was hacked, and private keys obtained. User funds will now be in a cold wallet, which only the user can unlock with their own private key. Lastly, it is worth noting that if we are to bring blockchain, cryptocurrency and trading to the mainstream, we will need to find a way to propagate instant finality. In a system which directly combats banks, settlement times and fees, this is one of the most important aspects. Users are turned off by having to wait for “x” amount of confirmed blocks before they can access their funds, however, there are a few projects in the works which strive for either extremely fast or instant finality on the blockchain ( e.g. Cosmos )
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